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The Best Bank Stocks of 2016

Bank stocks are rarely the market's best performers. You probably shouldn't want them to be if you've held them for a long time. The best years typically follow particularly bad years, which is the case for two of 2016's best banks.

So far, 2016 has been especially good for smaller banks, as a popular regional banking index is up about 22% year to date. Some have have done even better.Hancock Holding Company(NASDAQ: HBHC), Chemical Financial Corporation(NASDAQ: CHFC), and Cullen/Frost Bankers(NYSE: CFR)have made the most of 2016. The worst performer of the three is up 43% this year, nearly twice the return of its peer group.

Here's an introduction to 2016's best bank stocks, and why they're flying higher.

Banking along the Gulf

Hancock Holding Company operates nearly 200 branches along the Gulf of Mexico. In the booming days of domestic oil production, the company's bankers got ahead of themselves, making loans across the energy industry.

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Energy loans, which made up 13% of its loan book two years ago, now make up just 8.7% of its loan portfolio. It spent the better part of 2016 building up a substantial reserve against loan losses and now carries an allowance that amounts to 8.6% of its energy loans. In other words, it could lose about $0.09 of every dollar deployed in energy loans and take no further hits to its balance sheet.

Of course, direct energy exposure is only one slice of the pie. Hancock Holding Company has some indirect energy exposure in the form of commercial real estate loans in Houston. On a recent conference call, management indicated that it felt good about the prospects for getting repaid, noting few ill effects of lower oil prices and rents.

The market is increasingly viewing Hancock's problematic energy loans to be a problem of the past. With bolstered reserves and reduced exposure, shares recently topped $38, a level not seen since 2010, gaining nearly 55% this year.

Making a mint in Michigan

Chemical Financial Corporation operates under the names Chemical Bank (not to be confused with JPMorgan Chase's predecessor) and Talmer Bank and Trust, with 255 branches in Michigan, Ohio, and surrounding areas. It is most competitive in Michigan's smaller towns, including Midland, Clare, and Bay City, areas where it reported having 67%, 43%, and 29% of bank deposit market share, respectively, before a recent acquisition.

Chemical Financial is an acquisitive company. It closed on the acquisition of Talmer in the third quarter, which immediately brought the bank to eastern Michigan and Ohio. Two rivals, Huntington Bancshares and FirstMerit Corp., also merged this year, giving the new Huntington Bancshares more branches in the same geographic footprint.

On a recent conference call, management noted that it expected one-time costs associated with the merger to taper off through the second quarter of 2017, which would then allow for the combined earnings power to flow through to shareholders. A presentation called for itsefficiency ratio -- non-interest expenses as a percentage of revenue -- to be as low as 55% after the integration is complete, which is excellent for a regional bank.

Notably, its 2016 performance was compounded by the bank rally following Trump's presidential win. Its post-election gain of 13% tops the others on this list, who saw their shares swell by 10%. In all, shares have gained about 47% year to date in 2016.

A Texan titan

The rise in Cullen/Frost Bankers' share price has been remarkable, as shares are up nearly 100% from their 2016 low, and about 43% year to date. A true oil bank, Cullen/Frost has seen its share price largely followed the price of oil this year, up and down.

The energy businesses that fueled its loan growth are now taking a back seat. Cullen/Frost recently reported that 12% of its loans were to energy-related companies, down from 15.3% in December 2015. Its commercial real estate loan portfolio has some additional worrisome exposure to Houston, amounting to about 8% of total loans.

But where loans make up the vast majority of most banks' balance sheets, Cullen/Frost Bankers is an exception. Its loan and securities portfolios are roughly similarly sized, and thus it can afford larger losses on loans than the prototypical bank. Cullen/Frost charged off its biggest losers in the second quarter of 2016, reporting a net charge-off ratio of 0.74% during the period.

In the third quarter of 2016, charge-offs fell to 0.17% of loans, closer to its average charge-off rate in periods of high oil prices and economic growth. Management indicated on the second-quarter conference call that it expected charge-offs to normalize through the remainder of the year. So far, they have.

A recent regulatory stress test suggested the bank is on solid footing. The test concluded that Cullen/Frost would remain well capitalized -- and profitable -- in a significant economic downturn in which unemployment spikes to 10%, the stock market drops 51%, and commercial real estate prices drop 30%, among other worrisome assumptions. Beefier loan reserves, higher oil prices, and declining charge-off expectations have helped buoy shares this year.

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